Educational Articles

Federal Reserve Getting Ready to Shift Policy, Unless…

Robert Mitkowski
| September 09, 2013

The Federal Reserve appears set to soon start paring back its massive bond-buying program. A policy adjustment would represent a qualified victory over the deepest economic slowdown since the Great Depression, but also likely acknowledge the limits of the Fed’s powers.

Investors are concerned that the Federal Reserve will soon begin to reduce its $85 billion-a-month in securities purchases. But they might become more worried if the Fed found it necessary to keep the program going indefinitely, or even expand it. Sustaining the bond-buying full-force would potentially mean its intended benefits are not having their desired effect. And it would be a bad situation on Wall Street if the Fed were viewed as powerless.

Without a doubt, the Fed’s low interest-rate policies have produced notably positive results, especially with respect to demand for housing and autos. Unemployment has been a tougher nut to crack, of course, but that is often the case following recessions, particularly steep downturns like the one that occurred from 2007 to 2009. But now the time appears to be ripe for the Fed to declare victory and move on to the next stage of its agenda. On the whole, the Fed’s strategy to boost the economy without fueling inflation worked, to an extent. The economy improved and, although it did not boom, neither did inflation soar.

Europe’s emergence from recession at midyear and the reawakening of Japan’s economy provide signals that the time to worry about stoking inflation may be drawing closer. Granted, growth in the world’s developed nations remains muted and growth in up-and-coming nations is slower than it once was. But assuming no backsliding, now would seem as good a time as any for the Fed to ease off on the accelerator a bit.

Bringing the Fed’s balance sheet more in line with historical norms is another issue. The central bank’s holdings recently stood at nearly $3.7 trillion, way up from the $900 billion prior to the 2008 financial crisis. The good news is that the extra assets are not the exotic types related to the bailouts and emergency measures the Fed needed to resort to at the depths of the economic downturn. Currently, assets mainly consist of U.S. Treasury securities and federal agency mortgage securities.

It is difficult to measure how long, if ever, it will take for the Fed’s balance sheet to revert to the just under $1 trillion of assets that was standard for a long time. One industry source has estimated that $250 billion of assets held by the Fed may mature each year. If that proves about right, it would take the Federal Reserve more than 10 years to unwind the positions it has taken on to support the economy.

But the Fed would probably very much like to sell some of its holdings, as it has already done, for a profit, if it could do so without causing disruption in the markets. Asset sales would, of course, speed the return to what was once considered balance-sheet normality. On that count, the Fed will probably pick its spots.

Overall, it has been nearly five years since the recession in the United States ended and, with no recessions currently under way in any of the world’s major economic regions, this may be a good time for the Federal Reserve to reduce its use of the equivalent of financial rocket fuel to boost business conditions. With global growth still muted and the Fed’s zero interest-rate policy still in effect, long-term interest rates are probably not ready to take off. Only a couple of things would seem to stand in the way of the Fed steadily pulling back on its bond-buying. One is if military action in the Middle East were to prove disruptive. Another is if a fight in Congress over raising the debt ceiling were to develop, since such a dispute could hurt the economy.

At the time of this article, the author did not have positions in any of the companies mentioned.